Chapter 5: Evaluating Operating and Financial Performance 71

Chapter 5

EVALUATING OPERATING AND FINANCIAL PERFORMANCE

DISCUSSION QUESTIONS AND ANSWERS

1. Identify the types of financing typically used during each life cycle stage of the successful
entrepreneurial venture.

Refer to Figure 5.1.

Development and Startup Stages:
Type of Financing:
Seed and startup financing

Survival Stage:
Type of Financing:
First-round financing

Rapid-Growth Stage:
Type of Financing:
Second-round, mezzanine, and liquidity-stage

2. Describe the types of financial ratios and other financial performance measures that are used
during a venture’s successful life cycle. Who are the users of financial performance measures?

Refer to Figure 5.1.

Development and Startup Stages:
Financial Ratios and Measures:
Cash burn rates and liquidity ratios
Conversion period ratios
Users of Financial Ratios and Measures:
Entrepreneur
Business angels
Venture capitalists (VCs)

Survival Stage:
Financial Ratios and Measures:
Cash burn, liquidity, and conversion ratios
Leverage ratios
Profitability and efficiency ratios
Users of Financial Ratios and Measures:
Entrepreneur, angels, and VCs
Commercial banks

Rapid-Growth Stage:
Financial Ratios and Measures:
Leverage ratios
Profitability and efficiency ratios
72 Chapter 5: Evaluating Operating and Financial Performance

Users of Financial Ratios and Measures:

Entrepreneur, angels, and VCs
Commercial banks
Investment bankers

3. What are financial ratios and why are they useful?

Financial ratios are measurements that show relationships between two or more financial variables.

4. What are the three types of comparisons that can be made when conducting ratio analyses?

The three types of comparison that can be made with ratio analysis are trend analysis, cross-sectional
analysis, and industry comparables (benchmark) analysis.

5. What are the meanings of the terms “cash build” and “cash burn”? How do we calculate net
cash burn rates?

Cash build is the amount the firm receives on its sales calculated by net sales less the change in
receivables. Cash burn is the amount of cash a firm uses on its operating and financing expenses and
on its investments in assets.

6. How is the current ratio calculated and what does it measure? How does the quick ratio differ
from the current ratio?

The firm’s current ratio is calculated by dividing the current assets by the current liabilities. This
ratio measures the firm’s ability to pay off its short term debt in the near term. The quick ratio differs
in that it leaves out inventory in calibrating current assets.

7. Describe how a firm’s net working capital (NWC) is measured and how the NWC-to-total- assets
ratio is calculated. What does this ratio measure?

Net working capital is measured by subtracting current liabilities from current assets. NWC-to-total-
assets ratio is calculated by dividing NWC by the firm’s total assets (or average total assets). This
calculation measures liquidity of the firm with a higher percentage indicating a greater liquidity.

8. What is the meaning of leverage ratios? What are typical ratios used for relating total debt to a
venture’s assets and/or its equity?

Leverage ratios indicate the extent to which the venture is in debt and its ability to repay its debt
obligations. Typical ratios used are the total-debt-to-total-assets-ratio, debt-to-equity-ratio, and the
equity multiplier.

9. What is the importance of the relationship between a venture’s current liabilities and its total
debt?

The portion of total debt that is “current” represents those liabilities that will come due within the
next year. The percentage of debt held in current liabilities is a reasonable glimpse of the venture’s
reliance on debt soon requiring an outlay of cash. Ventures with higher percentages are more likely to
need to restructure their liabilities in the near future.
 Chapter 5: Evaluating Operating and Financial Performance 73

10. Describe the two types of “coverage” ratios that are typically calculated when trying to assess a
venture’s ability to meet its interest payments and other financing-related obligations?

The two types of coverage ratios used are the interest coverage ratio and the fixed charges coverage
ratio. The interest coverage ratio measures the venture’s ability to pay its annual interest liability and
is calculated by dividing EBITDA by the annual interest payment. The fixed charges ratio measures
the venture’s ability to cover interest and fixed charges. It is calculated by dividing the sum of the
venture’s EBITDA and lease payments by the sum of interest payments, rental or lease
payments, and the before-tax cost of debt repayments.

11. What are four measures used to indicate how efficiently the venture is in generating profits on its
sales? Describe how each measure is calculated.

The four ratios used are gross profit margin, operating profit margin, net profit margin, and NOPAT
margin. Gross profit margin is calculated by dividing the gross profit by the venture’s net sales.
Operating profit margin is calculated by dividing earnings before interest and taxes (EBIT), by the
venture’s net sales. Net profit margin is calculated by dividing net income (or net profit) by net sales.
NOPAT margin is calculated by: (EBIT x (1 minus the tax rate))/net sales.

12. Identify and describe four efficiency/return ratios that combine data from both the income
statement and the balance sheet.

The four ratios are sales-to-total-assets, operating return on assets, return on assets, and return on
equity. Sales-to-total-assets is net sales divided by average total assets. Operating return on assets is
EBIT divided by average total assets. Return on assets is net profit divided by average total assets.
Return on equity is net income (or net profit) divided by average owners’ equity.

13. Identify and describe the two components of the ROA model both in terms of what financial
dimensions they measure and how they are calculated.

The two components of the ROA model are the net profit margin and the sales-to-total-assets ratio.
Net profit margin measures the amount of sales that become net profit and is calculated by dividing
net income by sales. Sales-to-total-assets measures the how much the firm generates in sales with
one dollar of assets. It is calculated by dividing net sales by the firm’s average assets.

14. What are the three ratio components of the ROE model? How is each calculated and what
financial dimensions do they measure?

The three ratio components of the ROE model are the net profit margin (net profit/sales), asset
turnover (net sales/average total assets), and the equity multiplier (average total assets/average
equity). Net profit margin measures profitability of sales. Asset turnover measures how well asset
are utilized in the production of sales. The equity multiplier measures how the firm scales its assets
on a base of equity (through liabilities and debt).

15. Indicate some of the concerns or cautions that need to be considered when conducting ratio
analysis.
.
When conducting ratio analysis, it is important to compare “apples to apples” by consistent use of
the same inputs to the ratios (e.g. annual sales or quarterly sales). It is also important to understand
that certain ratios may simultaneously indicate undesirable and desirable aspects of the venture’s
74 Chapter 5: Evaluating Operating and Financial Performance

strategy and risk position. For example, an efficient use of trade credit can be interpreted as
advantageous use of inexpensive credit or as the assumption of a large amount of short-term
financial risk (low current and quick ratios).

16. From the Headlines – The Lovely Touch in Raising Cupcake Dough: You have been retained as a
consultant for Lovely Touch and tasked with assessing the financial viability of their commercial
ventures. What types of financial ratios would you enlist in your report to Lovely Touch?

Answers will vary: To fund growth internally, profitability (or contribution) will be important, as
will be the efficient use of limited capital. Useful ratios would include Gross Profit Margins, Net
Profit Margins, Sales-to-Assets Ratios, Return on Assets, and many others.

EXERCISES/PROBLEMS AND ANSWERS

Note: for readers who were introduced to financial statements for the first time in Chapter 4, you
may want to first work the “Supplemental Exercises/Problems” presented at the end of Chapters
1, 2, and 3 which were intended for readers who had a previous understanding of financial
statements.

2. [Liquidity and Financial Leverage Ratios] Refer to the Salza Technology Corporation in
Problem 1.

A. Using average balance sheet account data, calculate the (a) current ratio, (b) quick ratio,
(c) total-debt-to-total-assets ratio, and (d) the interest coverage ratio for 2016.

Using average account balances:

(a) Current ratio: Average current assets/Average current liabilities
= (($240 + $300)/2) + (($60 + $95)/2) = $270/$77.50 = 3.48 times

(b) Quick ratio: (Average current assets – Average inventories)/Average current liabilities
= (($240 + $300)/2 - ($151 + $204)/2)/($60 + $95)/2 = ($270 - $177.50)/$77.50
= $92.50/$77.50 = 1.19 times

(c) Total-debt-to-total-assets ratio: Average total debt/Average total assets

= (($60 + $95)/2 + ($15 + 15)/2)/($345 + $465)/2 = ($77.50 + $15)/$405
= $92.50/$405 = 22.84%

(d) Interest coverage ratio: Average EBITDA/Average interest

EBITDA = Net sales – Cost of goods sold – Operating expenses

2015: $375 - $225 - $46 = $104
2016: $450 - $270 - $46 = $134

Interest coverage ratio = (($104 + $134)/2)/(($4 + $4)/2) = ($238/2)/($8/2)

= $119/$4 = 29.75 times
 Chapter 5: Evaluating Operating and Financial Performance 75

B. Repeat the ratio calculations requested in Part A separately for 2015 and 2016 using
year-end balance sheet account data. What changes, if any, have occurred in terms of
liquidity and financial leverage?

(a) Current ratio:

2015: $240/$60 = 4.00 times
2016: $300/$95 = 3.16 times
The current ratio declined but still exceeded 3.0 times in 2016.

(b) Quick ratio:

2015: ($240 - $151)/$60 = $89/$60 = 1.48 times
2016: ($300 - $204)/$95 = $96/$95 = 1.01 times
The quick ratio declined to just slightly above 1.0 in 2016. Liquidity has gotten
poorer.

(c) Total-debt-to-total-assets ratio:

2015: ($60 + $15)/$345 = $75/$345 = .2174 = 21.74%
2016: ($95 + $15)/$465 = $110/$465 = .2366 = 22.66%
Total debt as a percentage of total assets increased in 2016 by less than one percentage
point.

(d) Interest coverage ratio:

2015: ($375 - $225 - $46)/$4 = $104/$4 = 26.00 times
2016: ($450 - $270 - $46)/$4 = $134/$4 = 33.50 times
Interest coverage increased in 2016 to above 30.0 times. The firm uses a small amount
of financial leverage (primarily from current liabilities) and maintains a very high
interest coverage ratio.

4. [Financial Ratios] Use the financial statements data for the Bike-With-Us Corporation
provided in Problem 3 to make the following calculations.

A. Calculate the operating return on assets.

Operating return on assets = EBIT/Assets = $30,000/$131,000 = 22.90%

B. Determine the effective interest rate paid on the long-term debt.

Effective interest rate = Interest/Long-term debt = $5,000/$50,000 = 10.00%

C. Calculate the NOPAT margin. How does this compare with the results for the net profit
margin? Did the owners benefit from the use of interest-bearing long-term debt?

Tax Rate = Taxes/EBT = $6,000/$25,000 = 24.00%

NOPAT Margin = [(EBIT)(1 – tax rate)]/Net Sales = [$30,000(1 - .24)]/$325,000 =
$22,800/$325,000 = 7.02%
76 Chapter 5: Evaluating Operating and Financial Performance

The Net Profit Margin was lower at 5.85%

Since the Operating Return on Assets (22.90%) was higher than the Effective Interest
Rate (10.00%), the firm benefited from having interest-bearing long-term debt.

5. [Cash Burn and Build] Following are two years of income statements and balance sheets for
the Munich Exports Corporation.

MUNICH EXPORTS CORPORATION

Balance Sheet 2015 2016

Cash $50,000 $50,000
Accounts Receivables 200,000 300,000
Inventories 450,000 570,000
Total Current Assets 700,000 920,000
Fixed Assets, Net 300,000 380,000
Total Assets $1,000,000 $1,300,000

Accounts Payable 130,000 $180,000

Accruals 50,000 70,000
Bank Loan 90,000 90,000
Total Current Liabilities 270,000 340,000
Long-Term Debt 400,000 550,000
Common Stock ($.05 par) 50,000 50,000
Additional Paid-in-Capital 200,000 200,000
Retained Earnings 80,000 160,000
Total Liab. & Equity $1,000,000 $1,300,000

Income Statement 2015 2016

Net Sales $1,300,000 $1,600,000
Cost of Goods Sold 780,000 960,000
Gross Profit 520,000 640,000
Marketing 130,000 160,000
General & Administrative 150,000 150,000
Depreciation 40,000 55,000
EBIT 200,000 275,000
Interest 45,000 55,000
Earnings Before Taxes 155,000 220,000
Income Taxes (40% rate) 62,000 88,000
Net Income $93,000 $132,000

A. Calculate the cash build, cash burn, and net cash burn or build for Munich Exports in
2016.

Cash Build = Net Sales – Increase in Receivables = $1,600,000 – ($300,000 - $200,000)

= $1,500,000
 Chapter 5: Evaluating Operating and Financial Performance 77

Cash Burn = Income Statement-Based Operating, Interest, and Tax Expenses + Increase
in Inventories – (Changes in Payables + Accrued Liabilities) + Capital Expenditures

Operating Expenses = Cost of Goods Sold + Marketing + General and Administrative =

$960,000 + $160,000 + $150,000 = $1,270,000
Other Cash Expenses = Interest + Taxes = $55,000 + $88,000 = $143,000
Increase in Inventories = ($570,000 - $450,000) = $120,000
Changes in Payables and Accrued Liabilities = [($180,000 - $130,000) + ($70,000 -
$50,000)] = $70,000

Capital Expenditures or Change in Gross Fixed Assets = Change in Net Fixed Assets plus
Depreciation = ($380,000 - $300,000) + $55,000 = $135,000

Cash Burn = $1,270,000 + $143,000 + $120,000 - $70,000 + $135,000 = $1,598,000

Net Cash Burn = Cash Burn – Cash Build = $1,598,000 - $1,500,000 = $98,000

B. Assume that 2017 will be a repeat of 2016. If your answer in Part A resulted in a net
cash burn position, calculate the net cash burn monthly rate and indicate the number of
months remaining “until out of cash.” If your answer in Part A resulted in a net cash
build position, calculate the net cash build monthly rate and indicate the expected cash
balance at the end of 2017.

$98,000/12 = $8,166.67
Cash balance at end of 2008 = $50,000
$50,000/$8,166.67 = 6.12 months (remaining “until out of cash”)

6. [Liquidity Ratios and Cash Burn or Build] The Castillo Products Company was started in
2014. The company manufactures components for personal decision assistant (PDA)
products and for other hand-held electronic products. A difficult operating year 2015 was
followed by a profitable 2016. However, the founders (Cindy and Rob Castillo) are still
concerned about the venture’s liquidity position and the amount of cash being used to
operate the firm. Following are income statements and balance sheets for the Castillo
Products Company for 2015 and 2016.

CASTILLO PRODUCTS COMPANY

Income Statement 2015 2016

Net Sales $900,000 $1,500,000
Cost of Goods Sold 540,000 900,000
Gross Profit 360,000 600,000
Marketing 90,000 150,000
General & Administrative 250,000 250,000
Depreciation 40,000 40,000
EBIT -20,000 160,000
Interest 45,000 60,000
78 Chapter 5: Evaluating Operating and Financial Performance

Earnings Before Taxes -65,000 100,000

Income Taxes 0 25,000
Net Income (Loss) -$65,000 $75,000

Balance Sheet 2015 2016

Cash $50,000 $20,000
Accounts Receivables 200,000 280,000
Inventories 400,000 500,000
Total Current Assets 650,000 800,000
Gross Fixed Assets 450,000 540,000
Accumulated Depreciation -100,000 -140,000
Net Fixed Assets 350,000 400,000
Total Assets $1,000,000 $1,200,000

Accounts Payable $130,000 $160,000

Accruals 50,000 70,000
Bank Loan 90,000 100,000
Total Current Liabilities 270,000 330,000
Long-Term Debt 300,000 400,000
Common Stock ($.05 par) 150,000 150,000
Additional Paid-in-Capital 200,000 200,000
Retained Earnings 80,000 120,000
Total Liab. & Equity $1,000,000 $1,200,000

A. Use year-end data to calculate the current ratio, the quick ratio, and the net working
capital (NWC) to total assets ratio for 2015 and 2016 for the Castillo Company. What
changes occurred?

Current Ratio = Current Asset/Current Liabilities

Year 2015: $650,000/$270,000 = 2.41
Year 2016: $800,000/$330,000 = 2.42

Quick Ratio = (CA - Inventories)/CL

Year 2015: ($650,000 - $400,000)/$270,000 = 0.93
Year 2016: ($800,000 - $500,000)/$330,000 = 0.91

NWC to Total Assets Ratio = (CA - CL)/Assets

Year 2015: ($650,000 - $270,000)/$1,000,000 = 0.38
Year 2016: ($800,000 - $330,000)/$1,200,000 = 0.39

B. Use Castillo’s complete income statement data and the changes in balance sheet items
between 2015 and 2016 to determine the firm’s cash build and cash burn for 2016. Did
Castillo have a net cash build or net cash burn for 2016?

Cash Build = Sales – Change in Accounts Receivable

= $1,500,000 - $80,000 = $1,420,000
 Chapter 5: Evaluating Operating and Financial Performance 79

Cash Burn = Inventory-Related Purchases + Administrative Expenses + Marketing

Expenses + Interest Expense - (Change in Accrued Liabilities +
Change in Payables) + Capital Investments + Taxes
= ($900,000 + + $250,000 + $150,000 + $60,000 + $25,000 + $100,000
- ($20,000 + $30,000) + $90,000 = $1,525,000
Net Cash Burn or Build = Cash Build – Cash Burn
= $1,420,000 - $1,525,000
= -$105,000 = $105,000 Cash Burn

C. Convert the annual cash build and cash burn amounts calculated in Part B to monthly
cash build and cash burn rates. Also indicate the amount of the net monthly cash build
or cash burn rate.

Monthly Cash Burn Rate $1,525,000 12 $127,083.33

Less: Monthly Cash Build Rate -$1,420,000 12 -$118,333.33
Monthly Net Cash Burn Rate $105,000 12 $8,750.00

7. [ROA Model and Expenses Related to Sales] Use the financial statements data for the
Castillo Products presented in Problem 6.

A. Calculate the net profit margin in 2015 and 2016 and the sales-to-total-assets ratio using
yearend data for each of the two years.

Net profit margin 2015: -$65,000/$900,000 = -7.22%

Net profit margin 2016: $75,000/$1,500,000 = 5.00%
Sales-to-total-assets 2015: $900,000/$1,000,000 = .900
Sales-to-total-assets 2016: $1,500,000/$1,200,000 = 1.250

B. Use your calculations from Part A to determine the rate of return on assets in each of the
two years for the Castillo Products.

Rate of return on assets 2015: -7.22% x .900 = -6.50%

Rate of return on assets 2016: 5.00% x 1.250 = 6.25%

C. Calculate the percentage growth in net sales from 2015 to 2016. Compare this with the
percentage change in total assets for the same period.

Percentage growth in net sales: ($1,500,000 - $900,000)/$900,000 = 66.67%

Percentage change in total assets: ($1,200,000 - $1,000,000)/$1,000,000 = 20.00%

D. Express each expense item as a percentage of net sales for both 2015 and 2016. Describe
what happened that allowed Castillo Products to move from a loss to a profit between the
two years.

2015 2016
Net sales 100.00% 100.00%
80 Chapter 5: Evaluating Operating and Financial Performance

Cost of goods sold 60.00 60.00

Gross profit 40.00 40.00
Marketing 10.00 10.00
General & administrative 27.78 16.67
Depreciation 4.44 2.67
EBIT -2.22 10.67
Interest 5.00 4.00
Earnings before taxes -7.22 6.67
Income taxes 0.00 1.67
Net income (loss) -7.22% 5.00%

The decline in general and administrative expenses as a percentage of sales (i.e., the
spreading of fixed costs) was the major contributor to Castillo becoming profitable. The
decline in depreciation expenses and in interest expenses as percentages of sales also
contributed to the move to profitability. However, increased taxes on profits reduced some of
the profitability gains.